When Americans think of Indian outsourcing, they visualize call centres doing low-level tech support and information technology (IT) companies fixing bugs in computer software. Indeed, that is where the Indian industry got its start. But while the West was literally sleeping, Indian outsourcers evolved into world-class research and development (R&D) machines.

Its call centre operators are now helping enhance patient care for US hospitals, optimize financial transactions for Australian banks and streamline parts management for European engineering firms. Its IT companies are developing mission-critical avionics systems, next-generation telecom technologies and complex medical devices.

Despite the limitations imposed by the country’s weak infrastructure and antiquated education system, India has rapidly evolved into a global knowledge and innovation hub.

Just 10 years ago, Indian IT companies such as Infosys Technologies Ltd, Tata Consultancy Services Ltd (TCS) and Wipro Ltd were bidding for small contracts to help Western companies fix the Y2K bug in their computer systems. Their customers were desperate to fix this ticking time bomb, but didn’t have the manpower or skill to do it. So despite severe hesitations, Western companies sent their mission-critical systems to India for repair.

Indian outsourcers used this opportunity to expand operations, build new skills and, most importantly, get to know their customers. The catastrophe was averted, and both sides benefited. Indian firms used this as a launching pad for bigger projects and entry into more strategic ventures.

The Indian industry faced a severe problem, however. It needed to hire hundreds of thousands of engineers, but the output of its engineering colleges was severely limited. In 1999, India graduated only 76,000 engineers, and most did not receive high-quality education. This number had doubled by 2004, but quality suffered.

The Indian Institutes of Technology produce world-class engineers, but they graduate less than 5,000 engineers in all every year. To make matters worse, the advanced types of engineering jobs Indian companies were bidding for required engineers with Master’s and PhD-level degrees.

In 2004, India graduated only 17,000 Master’s and 900 PhDs in engineering. The number of PhDs wasn’t even enough to staff its growing universities.

This resulted in fierce competition for experienced talent and caused huge increases in salaries and attrition rates. For a while, it looked like the Indian outsourcing industry would implode, like it had just been a flash in the pan.

Move forward to 2007. In that year, India’s top five IT companies (TCS, Infosys, Wipro, Satyam and HCL) added around 120,000 engineers. Accenture Plc and IBM India Pvt. Ltd added 14,000 each. Thousands of other smaller companies also expanded and recruited.

In 2006, India graduated at around 222,000 engineers. And most experts on Indian education agree that, at best, only half the engineers who graduate from Indian colleges are employable by technology companies.

So where did the magic happen?

The answer lies in the ability of Indian entrepreneurs to rise above all the hurdles the government and society throw at them. Just as India’s companies install their own power generators to deal with supply problems and purification plants to provide clean water, they have built their own surrogate education system. And herein lies India’s greatest innovation: Its companies have developed the ability to take the output of a weak education system and turn these workers into R&D specialists who can compete in the global arena.

Faced with severe talent shortages, escalating salaries and a lagging education system, Indian industry had to rethink the way it recruited, trained, developed and retained its workforce. It started by adapting the best practices of companies that were outsourcing R&D to India. Then, leading companies in diverse industries started improving on these techniques and methods; refining and integrating them into a unified system.

Here are some of the things they did…

Hiring for competence rather than skill: Résumés can fail to reflect the true aptitude and potential of job applicants or provide a basis for comparison, and educational degrees are often not a sufficient proxy for proof of skill and competence. So leading Indian companies started hiring for ability and aptitude rather than only specialized technical skills. They provided training to bridge skill gaps.

Employee training: Companies in India assume that new recruits will have to be trained virtually from scratch. So they invest substantial time, money and effort in doing this. Training is not relegated to less-experienced personnel; the most senior executives participate. Most large companies have built dedicated learning centres and some employ hundreds of training staff. Recruits usually get between one and seven months of training before they start work.

Continual employee development: Leading companies mandate that employees receive between one and three weeks of training every year in areas where they are weak. Some training is provided on evenings and weekends, but most is provided on company time. Many companies tie salary increases and promotions to the completion of such training modules.

Managerial development: Shortages in managerial talent have made it necessary to build pools of potential managers internally. Most companies offer extensive management training, internally and externally, through MBA-type programmes.

Performance management: Most companies have sophisticated systems that provide frequent feedback to employees and allow them to provide feedback on their managers. At HCL, employees not only review their managers, these appraisals are posted on the company’s intranet so everyone can review the employees’ assessments of their bosses. Parameters include performance, strategic vision, ability to communicate, problem-solving skills and responsiveness.

As a result, Indian IT firms have achieved some of the lowest attrition rates in the industry. American IT firms usually experience 20-30% yearly attrition rates. The top five Indian IT outsourcers average in the low-to-mid teens.

Workforce development helps to explain, for example, how IT service firms have been able to increase billing rates and productivity levels and maintain high levels of growth and profitability despite skilled-talent shortages, rising salaries and falling exchange rates, among other challenges. It also explains how firms in India are able to hire bright but largely inexperienced talent to successfully engage in R&D and other innovation.

With the economic slowdown, Indian talent supply has been able to catch up with demand. And Western companies are more desperate than ever to cut costs.

To achieve the 30-40% cost savings that Indian outsourcers can offer, they are now outsourcing their most strategic internal systems. Additionally, thanks to a combination of the recession in the US and that country’s flawed immigration policies, there is a flood of highly educated and skilled talent returning home to India.

They see more opportunity in India than abroad, and want to be near family and friends. They are returning with the latest skills and an understanding of foreign markets.

So the stars are lining up for Indian outsourcing, and this industry is gaining a second wind.

Within a decade, India is likely to become the world’s second-largest R&D centre after the US. Its innovations will likely benefit not only India, but also the world.